Don’t Fret German Austerity

Practicing what you preach is generally a good strategy in life—no one likes a hypocrite, right? So Germany’s new deficit reduction plans should thrill the rest of the eurozone. The austerity taskmaster is making cuts, too! They feel your pain!

As ever though, reality trumps reason: Germany’s decision to slash the deficit by €10.7 billion in 2014, balance the budget in 2015 and have a €5 billion surplus in 2016 is quite unpopular. Some even consider it harmful.

What gives?

This mindset stems from a common misunderstanding of the eurozone’s woes. Some believe the issue at heart is a balance of payments crisis: Germany, as a net exporter, has siphoned money from the periphery (so goes a common belief), causing big current account deficits around the Mediterranean and forcing these nations to borrow huge sums over time to fill the capital shortfall. In their view, to paraphrase John Maynard Keynes at 1944’s Bretton Woods conference, the surplus states in a fixed-exchange system must expand in order for deficit states to stop contracting. Ergo, they argue, Germany should spend more to goad demand at home so Germans can import more of the periphery’s goods, eventually evening the imbalances.

Problem is, the eurozone’s troubles aren’t on the demand side—they’re firmly rooted in productivity and economic competitiveness. In Greece, Portugal, Italy and Spain, bloated public sectors have taken up a large share of the economy for decades—and public sectors tend not to innovate or create wealth. Those private firms that did exist were too-often hampered by high taxes, restrictive labor codes, onerous regulations and other red tape—all of which made production costly and difficult, stymieing growth. So governments took advantage of cheap borrowing rates (thanks to the euro) and tried to boost growth through spending. It worked for a while, until the markets realized the system’s fragility. Then, borrowing costs rose and debt became unsustainable.

When you view the periphery’s struggles in this light, the idea Germany can save the day by importing more seems a touch simplistic—even if the periphery’s exports did skyrocket, their economies wouldn’t find lasting improvement absent reforms to address the deep structural issues. (Exhibit A: Spain, where exports logged their best-ever year in 2012 but the broader economy suffered.) Similarly, reducing unit-labor costs alone to make exports more competitive—an internal devaluation, in econ-speak—isn’t the ticket to lasting growth. Better to make all aspects of the economy more competitive: Slash the public sector (to give the private sector more room to operate), privatize unproductive state assets, remove regulatory barriers that prevent businesses from growing, make it easier to launch a business, and make labor markets more free. Do this, and businesses will innovate and produce more and, over time, help create more wealth.

Those last three words are critical: If you assume the periphery needs to export to Germany in order to gain capital, you assume the eurozone economy is a fixed pie. But that’s not true! Even in a currency union or any fixed-exchange regime, countries can create wealth domestically. This fresh capital can more than offset supposed current account imbalances. That’s how fiat money systems work—and the eurozone, despite its quirks, is a fiat system.

Given time, a combination of public sector cuts and economic reforms would likely help the periphery become a dynamic source of European growth. We might even see the initial fruits now, in the form of higher industrial production and business investment. Unfortunately, there’s a wrinkle: The IMF/ECB/European Commission troika is over-focused on near-term deficit reduction, and officials think tax hikes are necessary to achieve it. The troika has a rather large degree of influence over troubled member-states’ budgets—and officials tend not to approve budgets unless they contain an acceptable (in the troika’s view) level of tax hikes. Problem is, those tax hikes are often counterproductive. Higher corporation and commercial property taxes eat into firms’ profits, giving them less to reinvest in their business, and higher income and VAT taxes whack consumers. As a result, in places like Spain and Portugal, the private sector components of GDP—namely consumer spending and business investment—are tanking. Perversely, that’s putting deficit and debt targets further and further out of reach—shrink the denominator in the debt/deficit-to-GDP ratio, and the ratio rises even if the numerator (the absolute debt or deficit) shrinks a bit.

If the troika would drop its insistence on reaching arbitrary deficit-to-GDP targets, allowing troubled states more tax flexibility, I’ve a hunch we’d see much quicker economic improvement—the lasting kind, as economic reforms take root. Spain, Portugal and Italy have made great strides here. They have plenty further to go, but their labor markets and private sectors are freer than they were three years ago, and their public sectors are smaller. Yes, the latter means tens of thousands of workers have been displaced, but a growing private sector can absorb these folks over time. It can also yield higher tax revenues even if rates are lower, bringing more natural fiscal improvement.

And higher German imports simply aren’t a necessary part of this equation. I’m not arguing they wouldn’t help—exports boost economies, and economically strong Germany could perhaps be a bigger end market for the periphery. But so could the US, China, Mexico, Canada, India, Brazil, Singapore, Malaysia, South Korea, Thailand or one of the many other nations that’s growing right now. That’s the other thing—strong private businesses foster trade ties all over the world. This, too, brings in more capital. Hence why the EU’s free trade negotiations are paramount.

In my view, free trade and tax flexibility are where those lobbying Germany should focus. Forget the straw-man issue of German deficit reduction, and implore German officials to lead the charge on making the entire eurozone more dynamic and competitive. Then trade surplus and deficit states can grow alike, putting some silly economic notions to bed once and for all.